By Henry Hing Lee Chan

Will Tobin Tax Work in China?

Bloomberg reported on March 15 that the People’s Bank of China (PBoC) has drafted rules for a tax on foreign-exchange transactions that would help curb currency speculation.

The idea of such a financial transaction tax (FTT) — often described as a Tobin tax or "Robin Hood" tax — was first proposed in 1972 by Noble laureate James Tobin after the global financial system of fixed exchange rates (within a band) collapsed. It was initially suggested as a tax on spot exchange rate conversions to curb massive and destabilizing movement of funds during foreign currency exchanges. Tobin originally proposed the generated revenue to be used as aid for developing countries and administered by a multilateral financial agency such as the International Monetary Fund (IMF) or World Bank (WB). The idea has since been extended to cover a tax on all share, bond and currency transactions.

After the Asian Financial Crisis of 1990s, Tobin once again proposed the idea to reduce currency volatility. As that idea ran against the dominant Washington consensus at that time, it was not seriously considered. The proponents of the tax argued that it could have prevented countries such as Russia, Mexico and those in South East Asia from the need to raise their interest rates to very high levels when their currencies came under speculative attacks.

When the trading band of the RMB was widened in August 2015, volatility was induced. One month later, People’s Bank of China (PBoC) deputy governor Yi Gang proposed a Tobin tax to discourage short-term speculation in an interesting article written for China Finance magazine. His proposed tax would impose a fee on foreign exchange trades and short-term capital flows that contributes to the volatility of China’s capital markets.

The most famous Tobin tax was tried in Sweden in 1984, where a 0.5 percent tax was introduced on the buying and selling of shares. The results were disappointing. It has been hoped that about 1.5 billion Swedish kronor (£142 million) per year would be raised. On average however, only 50 million was raised. Capital gains tax revenues also fell. The impact on market trading was also dramatic. During the first week of the tax, the volume of bond trading fell by 85 percent and the tax was eventually scrapped in 1991.

Financial transactions taxes have been tried in various nations with often poor results. Aside from Sweden, implementation of a securities transaction tax flopped in Japan, the Netherlands, and other nations as financial transactions were diverted away from the imposing countries to its neighbor that did not impose such a tax. In France and Italy, the tax has reduced liquidity and financial growth.

The most important benefit on imposition of tax is to lessen the speculative demand in the financial market. Proponents of the tax also posited that it could be a huge money-raiser for governments and it is only fair that banks and other financial firms pay an additional tax to help tackle government debt problems that these institutions helped to create, as a result of their bailout schemes during the financial crisis.

On the other hand, critics argue that the tax will result in fewer financial transactions being made, resulting in job losses in financial centers. Others warn that the tax will also mean pension funds and savers receive less returns, as banks will simply pass the cost of the tax onto their customers. The most important argument against such tax is that the tax imposition needs global coordination in order for it to be effective. Countries imposing the Tobin tax will see their business diverted to neighboring countries that do not impose such tax. Critics said it has proved impossible to get global agreement to introduce it and the tax is impractical: a high rate would undermine financial markets, but if it were too low, it would not achieve its aim.

11 EU member countries: France, Germany, Italy, Spain, Austria, Belgium, Greece, Portugal, Slovakia, Slovenia and Estonia plans to introduce a financial transactions tax on June 2016 after postponement from initial implementation date of January 1, 2014. The tax will charge 0.1 percent on financial transactions between financial institutions against the exchange of shares and bonds and 0.01 percent across derivative contracts (equity linked, interest rate linked, currency linked). The revenue raised from the Tobin tax will be used to cut deficit of member countries. There are 28 members in EU and only 11 has indicated to join the implementation of the Tobin tax, while 8 members, Bulgaria, Cyprus, Czech Republic, Denmark, Luxembourg, Malta, Sweden and UK, expressed strong opposition to the proposed Tobin tax because the tax will not be done on a global basis.

The news leaked out of China is that the initial rate of the Tobin tax may be kept at zero to allow authorities time to refine the rules.

With a divided view on Tobin tax, how is the prospect of Tobin tax if it is introduced in China? Can it achieve the objective of reducing volatility in exchange rate or short term capital flow? Or will it go the way of circuit breaker in Chinese stock market, a policy tool that succeeded in other place but failed in China due to differences in market environment and absences of complementary reforms? If the Tobin tax is introduced in China, how should it be done? What are the other issues that the government should consider?

The news leaked out of China is that the initial rate of the Tobin tax may be kept at zero to allow authorities time to refine the rules. The tax is not designed to disrupt hedging and other foreign-exchange transactions undertaken by companies.

Favorable Factors for Tobin Tax to Succeed in China

The present market structure of China might give Tobin tax a good chance to succeed if its objective is to stabilize short term capital flow and exchange rate volatility:

First, China’s offshore capital market size is miniscule as compare to domestic market size. This unique market setup means there is no market arbitrage opportunity for speculators to move the business offshore to escape the tax once domestic Tobin tax is imposed. Domestic market will not lose its business to the overseas market.

Second, Chinese capital account is essentially closed and a Tobin tax can raise transaction cost and reduce market pressure in case of an elevated exchange rate or capital flow volatility. When the influx is high, Tobin tax can be slapped more on inflow. When the outflow is high, Tobin tax can be slapped more on outflow. Chinese monetary authority has a long history of directional lending and macro-prudential control, adding Tobin tax puts another tool on their hand in regulating the RMB or short term capital inflow or outflow. In this regard, Tobin tax is a policy tool directed against market players who are in the opposing side of the government policy direction. The mere availability of Tobin tax as a policy tool will dissuade many currency speculators from attacking RMB.Third, Chinese RMB offshore market targets current account item transaction while the onshore market is the real foreign exchange market as it handles both current and capital account transactions. It is relatively easier for Chinese authority to implement Tobin tax onshore and segregate the two types of transactions, thus minimizing unintended policy spill over effect to real economy’s current account transaction. Opportunities for policy arbitrage is much less than countries with free capital movement.

Fourth, EU’s embracement of Tobin tax has removed any charge of market intervention by free marketers. Tobin tax is not much of an ideological issue now.

Fifth, foreign exchange market participants are institutions and they will not behave unpredictably as compared to the stock market players of China. Chances of unexpected market reaction akin to violent circuit breaker introduction should not be much of a worry.

Others Issues to Consider When Tobin’s Tax is Introduced

Of course, few macro-economic benefits will not come without adjustment cost, the introduction of Tobin tax calls for the following changes in the current setup:

First, aside from the revenue generation benefit of the Tobin tax, the original idea of minimizing exchange rate and capital flow volatility means that regulations must be clearer when separating current account transactions and capital account transactions. We still want the exchange rate to reflect real economy’s demand and supply of foreign exchange and the idea of Tobin tax is to minimize the noise originated from short term capital flow on exchange rate. The success of Tobin tax to meet PBoC policy objectives lies on its implementing rules. There is a call on higher market surveillance capacity and governance standard by the PBoC.

Second, taxes add deadweight to transactions and the market will suffer drops in breadth and depth. Again, the implementing rules must try to ensure that the loss in breadth is in the undesirable area and the loss in depth will not hurt the real economy. In other words, how to do the damage control job well will attest to the technical skill of the policy makers. PBoC must analyze the impact of the tax on the real economy and calibrate its policies carefully.

Third, offshore RMB market was setup as a testing ground for eventual onshore RMB opening up. With the Tobin tax imposed in the onshore market, offshore market’s interaction with the onshore market should be carefully calibrated. This runs against RMB internationalization in the short term. The original sequence on RMB internationalization must be reviewed.

Tobin tax is a good short term policy tool when RMB is under unpredictable market stress and the current stand of PBoC to set it as a potential policy tool but defer its implementation is prudent. China’s unique market structure give the tax a fairly decent chance in succeeding in the event it must be implemented. However, the real issue is the implementation and the evil is in the details.

The recent exchange rate volatility has served as a wakeup call to the PBoC on market irrationality and the challenges that China might face in the next few years on its economic restructuring. If China succeeds in using Tobin tax to reduce the undesirable volatility in the exchange market with good implementing mechanisms, other countries will watch it closely and adopt Tobin tax in its tools kit. Many foreign exchange market players are expected to put up stiff resistance to the Tobin tax as it will make them a lot powerless in the market once the tax is implemented. Deputy governor Yi had to state publicly in China Development Forum last March 19 that the tax is still at research stage to dampen the heated opposition. Paraphrasing and modifying the famous 1992 US election slogan, “It’s the economy, stupid!”, in economics, “It’s the politics, stupid!”.